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implied volatility

Discussion in 'Options' started by tradingcards, Oct 18, 2007.

what exactly is implied volatility in options and how do you use that info to profit from it? I know the general definition of implied volatility, but i don't know what to look for with that indicator.

For example if an option has implied volatility of 100%, what does that mean and how should i use that

2. timbo

IV is the market's guess of future vols. Take the guess and compare with your forecast and then trade like a madman.

3. Wayne Gibbous

An option's IV is simply the variable solved for, when the other inputs to an option pricing model are known.

For example, to price a stock option you need: Stock price, expiration date, strike, dividends paid before its exp, risk free rate, and volatility.

If you already have an option quote from a MM, you solve for volatility as the unknown. IOW, what volatility input would make a call price of \$xx.x? That is the IV. It may, or may not have much basis compared to the stocks historical vol at the current time (expl the call price might indicate a big jump in vol, but the stock has not moved before earns), but can't remain far from it forever, or there would be a steady arb trade. So, as the other poster indicated, this would show that the "market" is pricing a future large move.

A trade could then be done (for exmpl), assuming the vol will return to more "normal" historic values.

4. Equalizer

IV is the wrong value that when plugged into an equation that is wrong (BS) because of the many simplifying assumptions, gives you the right answer (Option value).

If BS was correct then there'll be only one volatility wrt to moneyness and time to exp. Hence the vol surface would be flat. This is not the case, and clearly the market is pricing other forms of risk into the instrument.

As an aside, some traders are just very good natural pricers. A test was done some years ago and some of these guys would repeatedly price options with incredible accuracy when compared to results obtained via Ritchken-Trevor lattice (NGARCH sheah).

5. nitro

Do you have a link to that article?

nitro

6. Equalizer

No article, the tests were conducted at a few IBs that had just implemented the RT lattice at the time. I have no reason to doubt one of the guys from RT whom I know, both being nice guys.

7. donnap

IV mavens sometimes track IV and look for extreme readings - and assume a reversion to the mean. Various option strategies may be employed to try to take advantage of these situations.

Others may look for IV skews in an effort to buy low IV and sell high IV.

Good luck

8. nitro

Thanks.

I am not surprised by this at all. I remember an experience I had when I was in my late teens or maybe early twenties.

I was at my parents and they were socializing with the neighbors. They had just introduced the rubiks cube, and being bored by the conversation of people two to three times my age at the time (politics most likely), I ate my mothers delicious food and I struggled with rubiks cube. One face was trivial, but I was struggling with two faces.

One of the ladies, whom I had known most of my youthful life and rarely said a word to anyone, came over and asked what I was doing. I told her that I was working on trying to get all the colors of faces of this cube to line up, by rotating the faces. She looked at the cube, and took it from me.

Within five minutes, she had finished three faces, was struggling with the fourth, but was very close. I was astonished. For the first time in my life I realized that there are people wired to do certain things with no effort at all. This lady of sixty years old, if she had a secondary school education, would have been a miracle.

I thought about how this could be. I decided to learn all I could about her. She was from Colombia. It turned out that she was a seamstress, and she designed and created incredible clothes at amazing speeds, all with an ancient swinger sewing machine. I realized that she was doing group theory effortlessly and unconsciously, and that her work required her to think in multiple dimensions, keeping her mind and talent keen.

That was one of the biggest lessons of my life up to that point. I realized that true happiness (from your work life at least) comes from realizing what you are wired for, and then to find something that allows full expression of that.

nitro

if article does not exists , its very simple to check...

Sum of all ATM straddles premiums vs Absolute Sum of all intrinsic 30d later

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